Scorecard # 21 – Compounding Knowledge

Compounding Knowledge

The Value Fund was up +1.75% in Q1 vs. the S&P/TSX which was down -4.52% and the S&P500(CAD) which was up +1.74%.

Markets are off to a rough start in 2018 and volatility is on the rise. The prior calm lulled a number of “investors” to short the VIX (fear index), presumably because they believed that turbulent markets had been abolished. Their investments were recently wiped out. Regular readers will not be surprised to learn that we avoided this folly (and the Bitcoin mania as well).

Notes: All returns and Value Fund details are as of March 31, 2018, based on Class A units and are net of all fees. The Value Fund was launched on November 1, 2011. Prior to January 17, 2014 the Value Fund was managed by Lightwater Partners Ltd. while Mr. McCloskey was employed by that firm.

The U.S. dollar – which hurt us last year – strengthened and provided a 2.4% tailwind in Q1. These ups and downs tend to even out over time.

Our best performers for Q1 by portfolio contribution were Booking Holdings (Nasdaq:BKNG) +19.7% – a new position that we added to the portfolio in Q4 2017 when it was known as Priceline Group – and portfolio stalwart Cisco Systems (Nasdaq:CSCO) +12.0%. Our biggest laggards were Wells Fargo (NYSE:WFC) -13.6% whose challenges continue and American Express (NYSE:AXP) -6.1%. We also fully exited our position in Corus Entertainment (TSX:CJR.B) after they reported disappointing results. Overall, Corus was a good investment for us as we bought cheap, sold most of it last August at $13.92 and earned monthly dividends along the way. But the media industry is rapidly changing and the risks of continuing to own the name have increased so we decided to move on.

Express Scripts Holding Co.

We purchased shares in Express Scripts (Nasdaq:ESRX) in March. Longtime readers will recall that we have owned the stock previously and our previous articles on the company can be found here and here. But our reason for owning it this time is entirely different. Here’s what changed.

On March 8, 2018 Express Scripts announced that it had agreed to be acquired by health insurer Cigna Corporation (NYSE:CI) in cash and stock merger. If the deal closes, a holder of an ESRX share will receive about $91.00 in value, or a 31% premium to where the stock was trading at the time. As expected, Express Script shares rose on the news and Cigna’s declined. But then something interesting happened.

In merger situations like this, the target company (Express Scripts) will typically trade at a modest discount to the deal price to reflect the risk of the transaction not closing and time value (sellers don’t get their consideration until the deal closes). The discount is referred to as the merger arbitrage spread and it generally declines over time as closing becomes more certain and imminent.(1)

What is interesting is that the spread on this transaction ballooned to over 31% in early April and Express Scripts started trading at a price lower than the undisturbed price that the stock was trading at prior to the deal announcement. Read that sentence again. We think the proposed transaction is similar to the pending combination of CVS Health (NYSE:CVS) and Aetna (NYSE:AET). But that second deal has consistently traded at a more reasonable spread of 15% or less. We have yet to hear of a compelling reason why the Express Scripts spread is so wide. So we promptly analyzed the situation and bought Express Scripts for the portfolio on April 2. Here’s our rationale.

There are only two possible outcomes:

A.The transaction closes and we earn a 30% return. We have assumed that the transaction takes a year to close but if it closes by year end (management’s view), our annualized return will be closer to 40%.

B.The transaction doesn’t close. In this scenario, Express Scripts stock will sell off, but likely not much lower that where it is currently trading which is also close to our estimate of the stock’s intrinsic value absent the deal. But Cigna will be obliged to pay Express Scripts a break fee of up to $2.1 billion if the deal fails. A nice consolation prize which further mitigates our risk.

What are the odds of each outcome? As the financing for the transaction has been secured, there are only two feasible reasons why the transaction doesn’t close. First, the shareholders of both companies need to approve the deal. Express Scripts’ shareholders will certainly approve it given the deal premium. Cigna shareholders may not like the deal. But Cigna management initiated the deal and will do their best to garner support. In addition, Cigna’s shares are broadly held with the largest shareholders being passive index funds who are likely to follow management’s lead.

(1) Often, investors in Merger Arbitrage situations will go long (buy) the target and short (sell) the acquirer’s stock. By doing so, they benefit as the spread narrows but can lose heavily if the deal doesn’t close. We don’t short and even if we did, our investment thesis supports a long-ESRX position without a corresponding short position in Cigna.

The real risk is if regulatory approval from the U.S. Department of Justice is not obtained. We see no compelling policy reasons to block the deal, but you never know.

We think the odds of a successful closing are at least 50% (several analysts believe it is much higher, but we like to be conservative). If it does close, we earn a terrific, low-risk return. If its doesn’t, we may suffer a modest loss. The asymmetric payoffs and our familiarly with Express Scripts and its industry gives us comfort in making this calculated bet. To date, the spread has narrowed and we are up +10.9%. But it is early and only time will tell how this situation ultimately plays out.

If you are interested in learning more, our investment thesis in Express Scripts was published by Barron’s a few weeks ago. For hard core stock analysts, a more detailed investment memo containing our analysis can be found here.

We generally prefer investments in companies that will compound their value over time. However, in an expensive market where bargains are hard to come by, special situations like this can greatly enhance returns while still mitigating risk. To paraphrase Charlie Munger (below), you need to look for bargains wherever they present themselves. Finally, it is worth pointing out that we were in a position to act quickly on this opportunity because of our prior work on Express Scripts. Investment knowledge, like interest, compounds over time.

“The two rules of fishing are to fish where the fish are, and don’t forget the first rule.”

Charlie Munger

2018 Annual Meeting

GreensKeeper’s 7th Annual Meeting will be held on Wednesday, June 13 at 7:00 p.m. at our usual spot – the Mississaugua Golf & Country Club. Additional details can be found here.

If you are interested in learning more about investing, come join us! The meeting is open to clients, potential clients, friends and family. After a brief presentation, we open the floor to Q&A so please bring some tough questions with you.

If you plan to attend, just RSVP to either myself or Michelle Tait via email to help us to plan the logistics.